Traditional financial theory, while sound in many respects, makes the mistake of assuming that the decision-making process behind investing is always rational and unbiased. However, as outlined in Justin Partington’s previous blog post, the emerging theory of emotional finance highlights the need to account for unconscious emotional drivers in investment decisions. Picking up again from Professor Richard Taffler’s presentation on the subject at our IQ-EQ Thought Leadership Series events in London and Luxembourg earlier this year, I will now explore the specific role of the fund manager in recognising these emotional factors and meeting the needs of their investors in this regard.
Based on rigorous real-world research, emotional finance theory identifies the ‘hidden’ forces driving investor behaviour and financial markets and provides a language with which to talk about them. Developing an understanding of this theory and applying it to day-to-day dealings therefore presents a significant opportunity for managers in terms of unlocking potential for success.
Ultimately, in most financial environments, it is very difficult to predict how markets will evolve and what the outcome of a particular investment will be. As such, fund managers must often rely on their conviction; a vital ingredient of the investment process. Conviction can overcome anxiety and emotional conflicts while providing the necessary faith to absorb risk and invest.
However, when it comes to conviction, there is a happy medium. Investors often chase high-conviction asset managers, but having too much conviction is as bad as not having enough; both are likely to lead to underperforming investments. Evidence shows that managers with realistic convictions tend to yield more positive results.
Another core aspect of emotional finance theory is recognising the correct emotional drivers of investment. Popular misconception dictates that managers are driven by greed, fear and hope, but emotional finance theory asserts that the real drivers are excitement, anxiety and denial. Anxiety refers to the need to manage investor anxiety, while excitement stems from the potential to outperform expectations and to find a so-called “phantastic” investment – the likes of Snapchat and Uber. Emotional self-awareness among managers is sure to lead to better decisions.
Awareness of an investor’s emotions is equally key. While, consciously, investors may look for managers with strong conviction, what they really want is a manager who is emotionally ‘in touch’; someone who can carry their anxiety and provide reassurance and comfort in the face of an innately uncertain future. Unconsciously at least, investors are seeking emotional relationships with their fund managers.
In fact, generating alpha is really only part of a fund manager’s role; meeting investors’ psychological needs is almost more important than meeting their need for financial returns. The ability to sufficiently alleviate their clients’ anxieties will see managers earn the trust of those clients, which is pivotal to successful investor-manager relationships. Indeed, “to trust is to invest” and, fundamentally, clients will only invest their capital with managers that they trust and like.
Emotional finance may still be a new discipline, but it provides a much greater understanding of the intricacies of investing. Behind the theory lies a need for fund managers to develop long-standing relationships with their clients to overcome fear, garner trust and make carefully considered investment decisions. All in all, it pays to have emotional insight.